Two Stocks in the Pet Penthouse

October 01, 2003

By Amy Tsao In September, scientists unraveled the genetic makeup of the dog and were surprised to discover that man's best friend is far more similar to humans than are mice, the creature geneticists spend so much time studying.

The news came as no surprise to dog lovers, who more than ever treat Fido like a family member -- or better. In fact, all types of pets -- dogs, cats, gerbils, snakes, canaries, ferrets, and the like -- seem to get the family treatment these days. Some 64.2 million U.S. households reported owning a pet in 2002, up 19% from 54 million in 1992, according to industry group American Pet Products Manufacturers Assn. And those bonds between human and pet are translating into a $31 billion industry.

Pet superstores Petsmart (PETM) and Petco Animal Supplies (PETC) are cashing in on the trend. Petsmart, with net income of $88.9 million on revenues of $2.7 billion in fiscal 2002, and Petco, which earned $11.6 million on revenues of $1.5 billion, may not be as flashy as the hyped-up dot-com pet-pampering purveyors of the 1990s. But they do appear to be solid niche retailers on a steady growth pace, and the outlook is bullish on their stocks.

RECESSION-PROOF? Sean McGowan, analyst at Harris Nesbitt Gerard, sees pet food and supplies as almost a no-brainer of a business, an "industry that's getting growth just for showing up." (The firm performs no banking for either company, and McGowan doesn't own the stocks.) Aided by favorable demographic trends, pet food and supply retailing will average a respectable 6% growth annually in coming years, McGowan predicts, making Petco and Petsmart solid, nearly recession-proof investments that should continue to show strong results.

Other analysts are equally optimistic. "All told, we estimate that both retailers should be able to [expand] sales by 10% to 12% and earnings per share (EPS) by 18% to 20% over the next three to five years," wrote Bear, Stearns & Co. analyst Joseph Feldman in a Sept. 8 research report. (In the past year, the firm has performed banking services for both companies. Feldman doesn't own shares.)

That explains why each company's share price -- Petsmart at $23 and Petco at $31 -- has risen by about one-third year-to-date, far outpacing the 9% increase in the Standard & Poor's 500-stock index during the same period. Feldman rates the stocks outperform and expects Petsmart to hit $34 and Petco to hit $42 by yearend 2004.

BEYOND BASICS. The pet retailers are benefiting from a shift that began about 10 years ago, explains Jim Meyers, chief financial officer of Petco. Back then, supermarkets were the main purveyors of pet gear and food. But Wal-Mart (WMT) and other discounters gradually lopped off a major share of the market as the typical pet owner increasingly focused on price. At the same time, more affluent pet owners began turning more to specialty stores such as Petco and Petsmart, which offer a huge variety of products. Over the last decade, the dual streams of competition have cut supermarkets' share of the pet-food and supplies market from 65% to just 35%.

Lately, Wal-Mart, Petco, and Petsmart have solidified their hold. Pet-care-related sales at supermarkets, drugstores, and mass merchandisers other than Wal-Mart have been declining since the start of 2002 through June of this year, according to Information Resources, a consumer-products tracking firm. While Wal-Mart is the clear No. 1, Petco and Petsmart have also thrived with strategies that differentiate them from the huge discounter, especially Petco. Both see themselves eventually doubling in size to about 1,200 or more stores, up from 600 now for Petsmart and 640 for Petco.

Both retailers have been reformatting their outlets to be more consumer- and pet-friendly. From there, however, their approaches part ways.an Diego-based Petco is positioning itself as the pet-store equivalent of Whole Foods Market (WFMI), the upscale organic and natural-food retailer that earns big margins by selling high-end products that cost significantly more than mass-merchandise brands. Petco says this category accounts for about 65% of its sales. Food -- mainly brands only available in Petco stores -- accounts for about 30%.

GROOM AND BOARD. That product mix, in turn, is driving up operating margins, which last year reached 8% for the first time, says Meyers, who adds that Petco expects to increase its operating margins by 50 basis points annually. "It has never been our objective to be the biggest sales company," says Meyers. "We just want to be the best, have the highest profitability measures of any of the companies within the category." Analysts see EPS rising 26% in the fiscal year ending January, 2004, to $1.13.

Phoenix-based Petsmart has a broader "everyday low-price" strategy. That draws in more customers, but it also puts Petsmart in more direct competition with Wal-Mart, which has strong leverage with pet food and supply vendors. Petsmart Chief Financial Officer Tim Kullman says the company's prices are "very competitive, within about 5% of the cheapest discounter." But, he adds, "driving that traffic means customers walk out with other purchases."

Petsmart also is branching out into high-margin services, expanding the capacity of its 50 in-store grooming salons and testing its in-store Petshotel boarding concept in more markets. Management now forecasts that services revenues will rise to $185 million in fiscal 2003, up 20% from the previous year. That would bring revenues from services to 6% of Petsmart's expected fiscal 2003 total of $3 billion. Kullman calls services "a diamond in the rough" that it has only recently focused on.

PAYOFF TIME. Kullman says Petsmart's operating margins for 2003 will be about 7% but should increase to between 8% and 9% two years from now. "A lot of infrastructure has been built, and we're reaping some of the benefits," he notes, referring to store improvements that began in 1999. Analysts figure Petsmart's EPS will rise by a healthy 27%, to 93 cents, this year.

Even with Wal-Mart continuing to expand, the pet market should have enough growth over the next few years to keep both Petco and Petsmart financially healthy -- and their shareholders purring happily. Tsao covers financial markets for BusinessWeek Online in New York